Manulife US REIT - RHB Invest 2018-12-14: Fundamentals Remain Sound

Manulife US REIT - Fundamentals Remain Sound

Manulife US REIT remains a good proxy to the sound US office fundamentals, through its portfolio of seven high-quality commercial assets across the US. The outlook for US office space remains rosy on strong job creation and limited micro market supply.

While there have been some concerns based on potential tax reforms impacting its tax-efficient structure, we believe the probability of any drastic changes is low.

Positive rental reversions to continue.

The outlook for office demand in key gateway cities remains positive, with the continued improvement in the labour market and unemployment at record-low levels of 3.9%. This is reflected in continued positive rental reversions (+10.2% in 9M18) for Manulife US REIT, on top of its stable portfolio occupancy rate (96%) and higher valuations for its properties.

The supply of office space (2018-2020) across the micro-markets where its assets are located also remains minimal. As such, we expect rental reversions to stay positive at 3-7%, for 2019.

While Manulife US REIT’s portfolio debt is currently fully hedged, about USD108.5m (16% of total) of its loans are due for renewal in Apr 2019. As borrowing costs have risen considerably from the time of financing, we expect overall borrowing costs to increase by 30-40bp upon refinancing. However the impact will be cushioned by the organic rent growth from inbuilt rent escalations.

About 94% of Manulife US REIT’s rental portfolio have built-in annual rent escalation clauses and mid-term/periodic rental rate increases. On average, this should result in 2.1% pa growth in overall portfolio rental rates.

Speculation surrounding tax changes seems overdone.

There has been market speculation on potential tax reforms by the Trump administration, which could impact the current tax-efficient structure employed by Manulife US REIT. The speculation surrounds changes to the US portfolio interest exemption rule – which shields withholding tax on interest and principal on shareholder’s loans.

While visibility on this issue is still low, the probability of any drastic change is also small. This is as the current structure is used by a large number of private funds, and the change will have a broader impact on foreign investments in the US.

Management has also been proactively evaluating counter-measures in the form of increasing depreciation charges or changing the tax domicile entity, which could limit the impact such changes, if they take place. The worst-case impact is likely to be a 15% drop in distributable income.

Valuations are compelling.

Manulife US REIT offers a FY19F yield of 8.2%, which we find highly attractive. Our DDM-based Target Price is based on a CoE of 8.5% and terminal growth of 2%.

Key risks are changes to its tax-efficient structure, the ability to retain key tenants and an unexpected slowdown in office space demand.

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